2002 Nobel Prize Winner - Economics

Recent thinking in Economics: Nobel Prize winner 2002.

Nobel Prize Winners

2002 (Joint Winner): Daniel Kahneman

Daniel Kahneman is the Eugene Higgins Professor of Psychology at Princeton University (about midway between New York and Philadelphia in the United States) and Professor of Public Affairs at Woodrow Wilson School. Kahneman was born in Israel and educated at the Hebrew University in Jerusalem before taking his PhD at the University of California. He was the joint Nobel Prize winner for Economics in 2002 for his work on applying cognitive behavioural theories to decision making in economics.

Economics is often the subject of debate on whether it is a science or not. Those pure scientists would scoff at the very thought! Part of the problem with economics as a science is that experiments cannot be repeated successively to see if outcomes are stable in assessing the validity and reliability of hypotheses. The main reason for that is that economics involves human beings!

Much of economic thought has revolved around the rationality of decision-making. For example, perfect competition assumes that information is freely available and as a result there would be no incentive for any firm to charge a price above any other firm because consumers would always buy from the cheaper seller. More sophistication to the model is built in through adding various imperfections such as product differentiation, branding, brand loyalty and so on but there is still a base assumption that humans will behave rationally. Rational Expectations theory suggests that people will factor in their expectations of the behaviour of inflation into their decision making in determining wage demands, consumption habits and financial decision making.

Kahneman is a psychologist, indeed the first psychologist to be awarded the Nobel Prize in economics. His work, along with Amos Tversky, his long time colleague who sadly died in 1996, applied cognitive psychology to this notion of rational behaviour and changed thinking about the assumptions on which many concepts in economics are based. The work for which he received the Nobel Prize is termed 'Prospect Theory'.

Prospect Theory

Prospect theory focuses on how human beings view decision-making. Kahneman suggests that human beings have perceptual weaknesses built into our cognitive structure. Decision making can be intuitive (system 1) or reasoned (system 2). The degree of interaction between the two can result in changes to the way we make judgements and decisions.

He cites the example of 'Ames Room' as a case in point. In this, the viewer is presented with an apparently 3D rectangular room. There are two identical twins in the room but the perception is that one of the twins standing on the right hand side of the room is significantly taller than the one standing on the left hand side.

The Ames Room

Image: The Ames Room. Copyright: Reproduced with permission from AlSeckel, The Great Book of Optical Illusions, Firefly Books, 2002.

Diagram of the Ames Room

Image: A diagram of the Ames Room. Copyright: Reproduced with permission from AlSeckel, The Great Book of Optical Illusions, Firefly Books, 2002.

The reason is that the room is not rectangular but each surface is trapezoidal. The walls and the floor may be higher or lower than they appear because of their shape and this is what creates the illusion.

Kahneman looked at perception from perspectives that he referred to as 'intuitive' and 'preference'. The former happens almost automatically and is difficult to control and change - for example, the eye tells you that the room is rectangular, but the latter involves reasoning, judgement and control - you know that the room appears rectangular but in reality it cannot be because the visual cues - the children in the room - suggest something is wrong.

Framing

Kahneman took this basis of human cognition and applied it to decision making in economics. He suggested that 'framing' might be important in influencing decision making which, on first view, might appear to be clear cut. For example, if you have a choice between saving 5 lives and saving 1 life, which would you choose?

The rational choice would be saving the 5 lives.

Now think about this scenario. You have a choice between saving 5 lives or 1 life. The choice is saving the lives of a group of 5 people all of whom are convicted serial murderers and rapists or saving the life of the other individual who has lived a perfectly respectable life and who is a talented surgeon.

Now what would you choose?

The rational choice is clouded because there are different pieces of information being given to you that could make you choose the 'irrational' decision. Kahneman took this conundrum and applied it to decision-making where risk is involved. In business and economics, decisions involving risk assessment are central to individuals, businesses, governments and international bodies so his work opened up a whole new set of assumptions upon which economic theory could be modelled and assessed.

Take this question. Why would someone be willing to queue all night outside a department store to buy a coat in the sale and save £400 but not be prepared to invest £1000 into improved insulation in their house which would also save them £400? The amount saved is exactly the same but our approach to the decision is different. It simply is not rational.

Risk aversion or risk seeking?

Two key areas for Kahneman's work relate to risk aversion and risk seeking. Why do people each week spend £5 on buying lottery tickets in the almost certain knowledge that they are 'throwing away' that £5? The chances of winning the lottery (getting all six balls drawn correct) are so small as to be 1:14 million (see The Chances of Winning the UK National Lottery), yet every week millions of people are willing to risk losing their £5 for the very slim chance that they might win the ultimate prize.

It has been argued that if the Lottery were organised differently then it would increase the number who play. For example, if the numbers winning large sums were spread around rather than one person winning several million, more people might be prepared to commit more money to playing the lottery.

If the chances of winning were significantly higher, people would be prepared to risk losing more of their own money to secure a chance of winning. Such a view would be called 'risk seeking' but would appear to be irrational. If the chances of winning were reduced to 1:7 million, people might decide to spend £10 on tickets because they stand a better chance of winning but in reality the chance is still very small and instead of 'throwing away' £5 people are now prepared to 'throw away' £10!

Framing might also be important in determining decision making in terms of how choices are presented. Assume that the West is alerted to an impending famine in sub-saharan Africa. Aid agencies on the ground estimate that governments need to provide $500 million to avert a human disaster. Would decision making on whether to grant the $500 million be different if the consequences of that decision were framed differently?

  • 'Spending $500 million will ensure that 75% of those affected by the famine will survive.'
  • 'Spending $500 million will lead to the deaths of 25% of those affected by the famine.'

Which of the above sentences would you prefer to base your judgement on?

Decision making therefore could be a fairly hit and miss affair, some decisions may be based on the immediate intuitive approach, whilst others may be made in the light of more considered reasoning - neither of which is necessarily right or better than the other. The point as far as economics is concerned is that decision making is not necessarily based on rational principles which could have an influence on all areas of economic theory - the theory of consumer choice, markets, the theory of firms, macroeconomic theories and finance economics all base much of their fundamental hypotheses on an assumption of rational behaviour.

Kahneman cites the work of Bernoulli which goes back to 1738! Bernoulli's work on utility (the degree of satisfaction derived from consumption or outcome) suggested that decision making was based on expected final outcomes. Kahneman suggested that this had been the foundation on which economic analysis had been based for 300 years. He further suggested that this was contradictory to the analogy that the discussion on perception suggested. That is, that utility depends not only on the final outcome but on the initial position of the decision maker because this position determines the degree of gain and loss associated with decision making.

Kahneman exemplifies this through the following example:

Which would you prefer - a 50% chance of winning $150 or a 50% chance of winning $100?

The gamble has an equal chance of winning and losing and Kahneman's experiments suggested that people would reject this unless the size of the prospective winnings was at least twice as much as the possible loss.

He then compares that with a second set of choices:

Would you prefer a decision that guarantees a $100 loss or would you rather take a gamble where the chance of winning $50 was rated at 50% but the chance of losing $200 rated also at 50%?

In this case, respondents went for the gamble rather than go for the choice that guarantees a loss. In this case, Kahneman suggested that respondents were 'risk seeking'.

The rational choice in the second example was to go for the certain loss because in the gamble there was every opportunity to end up even worse off by $200.

Such a 'rational' choice can be seen when looking at firms' behaviour. If a firm makes subnormal profit, at what point should they shut down? The theory suggests when revenue is insufficient to cover variable costs but in reality the choice may be more complex because of the perceived degree of risk involved. There is a chance that the firm could continue and overcome its problems and benefit in the longer term but there is also a chance that the firm could lose even more in the long run if things do not get any better.

The same situation appears when looking at share dealings. If a share price is falling do you sell now in the expectation that share prices will continue to fall or do you wait and see if things will get better. Is it better to lose £1 million now or £2 million two months down the line?

We could also apply this thinking to indifference curve analysis. Consumer behaviour is assumed to be dependent on the degree of utility gained from the consumption of one extra or one fewer goods - there will be an incentive for consumers to change their behaviour if consumption of one extra good yields a greater degree of utility than another to the point where total utility cannot be increased any further and the marginal utility derived from the consumption of the two goods was equal. This model however does not make any reference to the starting point of consumers in terms of the degree of utility they already have.

The perception of gains and losses

Kahneman therefore suggested that the 'framing effect' referred to in terms of perception also has relevance to decision making in economics. He suggested that a move from a risk aversion choice to a risk seeking choice could not be explained by final outcome alone. Preferences, he argued, are influenced by perceptions of gains and losses and were dependent on the position of the decision maker at the time of making the decision - a 'defined relative reference point'.

To see this in more perspective, Kahneman offers another choice problem.

Assume you start off with a given amount of wealth called 'W'. Which of the following choices seems more attractive?
Choice A would leave you with W - $100
Choice B would leave you with W + $150

The first question you might want to ask is how much does 'W' represent? If 'W' = $100 neither choice may seem attractive but if 'W' = $1,000,000 the gamble may be worth taking - the risk element changes; in the first case, the decision maker will be risk averse - you do not have much already, there is no point risking losing everything but in the second, if you lose $100, so what? It is only a small proportion of your total wealth, the prospects of 'winning' an extra $50 and the framing effect of the value of 'W' makes the decision maker a risk seeker.

Judgement by heuristic

Kahneman develops the question of decision making through what he refers to as 'Judgement by Heuristic'. The word 'heuristic' means assisting the process of learning or discovery - guiding or furthering investigation. Kahneman was interested in finding out to what extent our decision making was influenced by our perceptions, emotions and prior knowledge. We can illustrate this principle by reference to another example.

Two people arrive at the casualty unit of a hospital.

Patient A is a 25 year old male with a long record of 'joy riding' and car theft. He has arrived at the hospital with severe injuries following a car accident in which he was the driver. He is significantly over the legal limit for the amount of alcohol in his blood and there are suggestions of other illicit drugs in his system.

Patient B is a 95 year old widower who lives on her own. She is widely respected in her community as a friendly, caring and considerate neighbour. She was on her way home from a local shop when the car driven by Patient A, swerved, mounted the pavement and ploughed into her. She has serious pelvic and head injuries.

The hospital only has the resources to treat one patient. Which one should they treat?

Such a scenario might seem extreme but some years ago in the UK a case served to highlight a similar dilemma. A young person diagnosed with a serious form of cancer was given only a limited lifespan by doctors. An experimental treatment became available and the representatives of the young person insisted that the local hospital try out the treatment on the young person. The hospital refused arguing that there was only a 5% chance of the treatment working and that their resources would be better used elsewhere treating those for whom the chance of success was greater. The furore surrounding the case was extensive arousing strong feelings on both sides of the debate.

As far as Kahneman's argument is concerned, the influence of our emotions, the intensity of our fears, the possible outcomes and opportunity costs will all affect our judgement and the way we arrive at that judgement and consequent decision making may well be very different.

Governments therefore making decisions on allocation of resources on health, education, social welfare and so on could all be affected by such heuristics. What may be the rational and logical choice is not often the main factor in determining decision making.

An interesting illustration of the principle of heuristic judgements can be found by following the test Decision Making and the Availability Heuristic.

The number and quality of cues in decision making - the issue of uncertainty

The test suggests that we make judgements based on incomplete knowledge and in doing so make errors in those judgements. For decision makers in business and economics, the availability of knowledge to enable sound judgements to be made can have important consequences. The Enron disaster is a case in point. The reason the US authorities are going after the culprits in this case with such vigour is because the information being put out by the company to shareholders and prospective investors and other stakeholders was wrong and misleading. If you cannot trust the information you cannot be expected to make accurate and informed judgements.

The decisions of the Monetary Policy Committee of the Bank of England might be based on rational analysis of the data in front of them. Their decisions affect millions in the UK and elsewhere. What if the information on which they based their judgements was inaccurate? How does each member of the Committee arrive at their judgement when it comes to the vote?

What does each of these three images conjure up in your mind? What sort of person is each of these three people? What job do you imagine the first two people doing? Where do they live? What qualifications do they have? If you were a manager of a business and they came for interview, would you employ them? If you were going down an underpass and each of these people came the other way what would your reaction be?

The point of this is that we will draw inferences and judgements about people that could affect decision making - much of the judgements will be completely irrational but we will make them all the same. We will draw on our existing knowledge to help arrive at these judgements, for example, we might have a mental picture of punks and skinheads and use the information we know about them to make an assumption about this particular example of the genre. We have lots of information about Princess Diana and as such bring that to bear in our decision making about the sort of person she was and what she represents.

Kahneman would point out that the judgement could be very flawed indeed. A member of the public goes into a shop and is confronted by a sales assistant dressed in bondage trousers, black string vest liberally holed, having dyed green hair in a spiky arrangement and covered in tattoos and body piercing. She asks for some help with an item she is looking for. Three days later the shop receives a letter explaining how she approached the assistant with trepidation but was ashamed to admit that what she expected - a lout - turned out to be very articulate, very helpful and extremely polite. This is a true story by the way!

We make our judgements based on incomplete analysis of the situation because we have incomplete knowledge.

Other cases where such judgements may be irrational relate back to the 'fuel protests' that occurred in the UK in 2000. Motorists got very angry at the amount of tax imposed on fuel in the UK. An extra 2p per litre was considered the straw that broke the camel's back. For the average driver filling up their tank with 50 litres of fuel once a week this might amount to a weekly extra sum of £1. The tax raised goes towards paying for the many public services that many people rely on to improve their quality of life - education, health, social welfare benefits, emergency services and so on.

One comment at the time highlighted the apparent irrationality of the protests. A customer in a shop had just bought a 'Billy Bass', the singing fish on a plaque, for £30. The customer during the purchase was discussing the fuel protest with the shop assistant and was expressing his anger at the 2p rise in duty describing it as daylight robbery and a disgrace. Need I say more?

Kahneman was therefore attempting to place an importance in heuristic judgement on the number and quality of the 'cues' that exist to help our decision making. When few cues exist, decision making may well be based on intuition or reason as outlined earlier and referred to as 'system 1' and 'system 2'.

The work he and Tversky carried out over a long period serves to enrich the research into economics in a wide variety of ways and in some cases serves to question the basis of the underpinning philosophy of economics - that of rational behaviour since it raises the question of what we mean by 'rational' behaviour in the first place.